European Headwind: ECB Policy and Fed Normalization

Abstract

The monetary policy of the ECB and the Fed over the past few years are compared and contrasted. The two central banks have similar price stability objectives and faced similar conditions early in the crisis, including the zero bound on short-term interest rates. Since mid-2012, their policies have diverged dramatically. The Fed has pursued consistently expansionary policy through a large expansion of its balance sheet, contributing to significantly better outcomes with respect to both inflation and growth. By contrast, the ECB has tightened policy by reducing its balance sheet by one third. Judging from the weakness in money and credit growth, this policy has been inconsistent with the ECB’s two-pillar strategy. The outcome has been economic stagnation and a harmful disinflation that is inconsistent with the ECB’s mandate. The paper explores alternative explanations for this policy, including the role of politics in managing the euro area crisis. It proposes a policy of balance sheet expansion that would promote better fulfillment of the ECB’s mandate and outlines the implications of developments in the euro area for Fed normalization.

Keywords: ECB, Federal Reserve, central bank mandate, price stability, zero bound, monetary pillar, balance sheet, quantitative easing, euro area crisis.

JEL Classification: E52, E58, E61